Archive for the ‘timing’ Category

There are three well-known ways of valuing the stock market that are based on publicly available information.

Two are based on earnings: 1) The ratio of total stock market capitalization to gross national product (GNP). The market cap. to GNP ratio was popularized by Warren Buffet. 2) A cyclically adjusted PE ratio (typically a 10-year PE ratio). The 10-year PE was popularized by Robert Schiller (but not first proposed by him).

The other ratio is Tobin’s Q, similar to a market price-to-book ratio. It measures the replacement cost of publicaly traded companies.

Taken as a whole, where do these indicators stand?

The total market capitalization of US stocks is approximately 15.5 trillion, as of the last trading day of the year.

The GNP at the end of SEP 30 was 15.4 trillion. In other words, the Buffet ratio ratio is roughly 1. According to Buffet, that is average; he considers a ratio of around .75 to be a good deal. In his 2001 article when the ratio was 1.3, he suggested the market might return 7% annually over ten years (it yielded around 2%).

Schiller publishes the 10-year PE ratio on his Web site. It is currently 21, in comparison to the historic average of 16.4. Again, the market seems to be overvalued, or at least no screaming deal.

Finding values for Tobin’s Q is a bit more complicated. There is a Web site run by Smithers & Co. (an asset manager) that tracks it. According to that source, the market is roughly 33% overvalued (it was 29% overvalued on SEP 30).

What other buy/sell signals are there for the market as a whole? Valuation indicators are bets on mean-reversion. What about betting on the trend? The market is just below its 200-day moving average. Nothing bullish there.

There is one overwhelming bullish economic signal. The yield curve is substantially positive. A difference of more than 65 basis points between the 3-month and 10-year Treasury is bullish. The current spread is 187 basis points. But, that is because the 30-day Treasury yields virtually nothing. This is an economic indicator, rather a stock market indicator per se, although it is histocially correlated with bull markets. It probably stimulates the market because the world’s main investment choices are corporate and sovereign, and sovereign debt is expensive when rates are low.

Can amateurs time the market? Some simple, non-proprietary indicators that make sense:

The 200-day moving average profits from trends. In this system, the market is trending upward when it crosses its moving average (buy), and falling when it corsses below (sell). The system fails in cyclical markets, i.e where mean-reversion profits. (See Faber and Hulbert)

The multi-year (5 to 10 years) PE ratio is cyclical. It’s a bet on mean-reversion. Logically, it’s a good complement to a trend-following system such as a moving average. (See Hussman and CXO Advisory)

A normal yield curve, in which 10-year Treasuries are more than 65 basis-points higher than 90-day Treasuries is strongly correlated with bull markets. (See Crossing Wall ST and a more recent look). However, the yield curve right now is considered by some to be abnormal, because the government is keeping short-term rates at near 0%. See this interview with bond-expert Van Hoisington for example.

What would happen if you just invested in thirds? Put 1/3 of your portfolio into the market when it’s above the 200-day moving average (thus capturing the profit available due to trending). Invest another third when the market’s long-term PE ratio is at or below average (capturing the profit predictable from mean-reversion). And add the final third based on the yield curve.

Another overall valuation metric is the ratio of total stock market capitalization to GNP or GDP. This could supplement the 10-year PE ratio, or you could break the portfolio into fourths, giving it more of a value-tilt. (See Warren Buffet and Motley Fool)

Where to find the data:

Buffet’s ratio. GDP-version: gurufocus.com (it predicts the market is at the high-end of fairly valued, with a likely annual return of 5.1%).

The yield curve: US Treasury …use the 3-month and 10-year columns (currently very bullish, but note concerns about atificially low interest rates right now).

* Day-late update: There is also Tobin’s Q, which is similar to book value. See Smithers, which also mentioned Schiller’s 10-year PE ratio (called “CAPE” for “cyclically adjusted”), and Equities and Tobin’s Q. Tobin’s Q also suggests the market is slightly overvalued.
* Another source of info on Buffet’s and Schiller’s market valuation methods is MyPlanIQ.

Another good article on the current stance of the yield curve:
http://www.capitalspectator.com/archives/2012/01/is_the_yield_cu.html